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Pacific Crest’s Apple analyst, Andy Hargreaves, raised his rating on Apple from Sector Perform to Outperform based on the iPhone 6 having a 4.7 inch screen and selling for a subsidized price of $299. He also believes that given the low valuation of the shares at 6.5x Enterprise Value/Earnings Before Interest Taxes Depreciation and Amortization (EV/EBITDA) and the “optionality” of new categories that there is limited downside to the shares. Hargreaves also expects only one new iPhone form factor this year and that it will be launched in September or October. Given the lost sales Apple has incurred by not having a larger screen iPhone I lean to two new form factors and bringing at least one to market in the spring/early summer. (Note that my family and I own Apple shares and have sold put options, a bullish position).

Replacement and loyalty are key factors favoring Apple

WDS, a Xerox company, published a report last month that indicated 76% of Apple customers upgrade from one iPhone to the next and had the highest retention rate of any smartphone vendor. Apple lost 15% of its users to Samsung and then it dramatically fell to 2% or less for any other smartphone provider.

Hargreaves is assuming that 35% of iPhone upgrades will chose the larger screen iPhone and capture 10% of the large format Android market. These seem to be reasonable estimates given users loyalty to Apple and the hammering it has taken by Android smartphones by not having a large screen version.

He is projecting that replacement sales will account for 70% of total iPhone sales in fiscal 2014 and 80% in fiscal 2015. This would add $4 to his fiscal 2015 EPS estimate of $40.92 (note that it is substantially below the Street’s $46.22 projection).

Valuation and new opportunities mean limited downside

Apple’s $142 billion net cash position (20% of market cap when you set aside $20 billion to run the business and fully tax the overseas cash) is well known as is its PE multiple of 12.5 on fiscal 2014 earnings. Hargreaves is not projecting much from China Mobile’s LTE rollout or revenue or profit from new product categories so there would be more upside to his estimates if either were to materialize in a meaningful way.

His target price of $635 is based on his new iPhone assumption, iPad shipments remaining flat at 70 million per year and the valuation remaining constant. He has a bull case with a target price of $700 based on increased iPhone and iPad shipments and profits along with new categories being launched and an increase of the EV/EBITDA multiple from 6.5x to 7.5x. His bear case is $465 with increased competition, the iPhone 6 selling for $199 and the multiple falling to 5.0x.